Sunday, February 28, 2010

Price is What You Pay, Value is What you Get

As the common saying goes: "Price is what you pay, value is what you get."

This saying is supported by people who support fundamental analysis. These are the faithful followers of legendary investors like Buffet, Fisher, Graham and the like.

Not too long ago, I wrote a short post on the 7 Investment Sins many investors make. Today, I am expanding on one of these "sins" which is basically people ignoring a stock's valuation when they purchase it at a certain price.

But before we can even go there, there is a difference we need to make between the PRICE of a stock and the VALUE of a stock.

In fact, Warren Buffet notes that there is really no distinction between value investing and growth investing as both are so integrally linked that any true investing must be based on an assessment of what the relationship is between price and value. Wise words indeed. Buffet goes on to suggest that any investing strategy which does not employ a comparison between price and value is tentamount to speculation.

So What is Price?

The price of a stock fluctuates from day to day. It's price can easily be determined either by turning to the Bloomberg channel or by checking up with your local stock broker. The price of a stock is what Mr Market offers you on a particular time and day. It changes from time to time and seems to be irrational at times.

Benjamin Graham's Mr Market is used to describe the price fluctuations that take place in the market. He appears daily and names a price where he would either buy or sell you a certain stake in a certain business.

Mr Market being moody and prone to maniac swings from joy to despair offers prices that are sometimes higher, sometimes lower than the value of businesses that are being traded on the stock exchange.

To put it simply, the price of a stock DOES NOT EQUAL to the value of a stock.

What is Value?

Valuing a stock is based on certain principles. Many people use price multiples. This include the simple price to earnings, price to sales and price to book ratios. These ratios however are based on price and basically compares what investors are paying for one stock to another stock. It does not really tell you anything about the value of a stock.

Morningstar believes that stocks should be purchased because they are trading at some discount to their intrinsic value. The value of a stock is calculated based on the present value of its future cash flows. To calculate an intrinsic value, the following steps are used:

1. Estimate cash flows for the next year
2. Forecast a growth rate
3. Estimate a discount rate
4. Estimate a long-run growth rate
5. Add the discounted cash flows to the perpetuity value.

After this is done, one goes on to calculate the Margin of Safety. This margin of safety is basically the discount price of the stock compared to your calculated valuation. It has been suggested that an average of 30 percent to 40 percent margin of safety should be present before the fundamental analyst purchases a certain stock.

The question is this: "Do people even bother to calculate intrinsic value and the margin of safety they have before they purchase a stock?" Do you?

5 comments:

  1. "I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities." - Benjamin Graham


    http://createwealth8888.blogspot.com/2010/02/what-will-benjamin-graham-say-today.html

    ReplyDelete
  2. Many people dream of and seek financial freedom... but very few find it. The reasons are mainly psychological in nature. In short, most people do not cultivate and exercise the mindset and behavior that is necessary to achieve financial freedom. The ways to financial freedom are: Saving-and-investing, being an Employee, Self-Employed.

    ReplyDelete
  3. I never knew Benjamin Graham said that.

    Hi Zander,
    Yes, very few people attain their goals because of a lack of focus. Goals need to be SMART at the end of the day. There are many roads to financial freedom and I would like to think whichever path one takes really depends on the individual.

    ReplyDelete
  4. Nice article.

    To me, calculating intrinsic value and then insisting on a decent margin of safety have always been the cornerstone of my stock investing philosophy.

    But you are right .... most people don't really care about valuing stocks. After all, it is hard work.

    ReplyDelete
  5. Yes Independent Stock Investing,

    It is way too much hardwork for the normal person on the street. In fact, his time could be perhaps better spent finding another part time job.

    But of course, the rewards of uncovering a ten bagger is unspeakable

    ReplyDelete

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